Posts Tagged ‘Animal Spirits’

Theories of the Financial Crisis: Animal Spirits

Monday, May 11th, 2009

David Brooks is a reliable barometer of the opinions and beliefs of the Washington establishment (and I don’t mean that as an insult.) The figure he cuts is a rather odd combination of an amateur (but insightful) anthropologist and a insider protecting the system. All of this makes it significant to note that David Brooks has on several occasions stated that the root of this financial crisis is a “loss of confidence.” He has stated this in several of his columns, including his one immediately following the September 15 freefall:

At its base, the turmoil wracking the world financial markets is a crisis of confidence.

Many of Geithner’s critics have said that he is treating the financial crisis primarily as a liquidity crisis – which is defined as “a ‘general feeling of mistrust in the banking system’ conducting to a temporary disappearance of credit.” This is a common form that a crisis of confidence in the financial system takes.  

The Congressional Oversight Panel in their report [pdf] written to evaluate the TARP bailouts, for example, described what they saw as one of Geithner’s asusmptions :

One key assumption that underlies Treasury’s approach is its belief that the system-wide deleveraging resulting from the decline in asset values, leading to an accompanying drop in net wealth across the country, is in large part the product of temporary liquidity constraints resulting from nonfunctioning markets for troubled assets. The debate turns on whether current prices, particularly for mortgage-related assets, reflect fundamental values or whether prices are artificially depressed by a liquidity discount due to frozen markets – or some combination of the two.

Paul Krugman has also often made this point – stating that Geithner seems to be acting as if we were in a liquidity crisis – in which the loss of confidence is the cause of the problem – instead of a solvency crisis – in which the loss of confidence is a symptom of the problem. 

Geithner, for his part, rejects this assertion that he is treating the problem as a liquidity crisis. When asked, he said it was, as all financial crises are, a combination of the two.

If this is primarily a crisis of confidence, there have been a number of historic examples of how these were contained. For example, this is a description of the resolution of the Panic of 1907 – in which J. P. Morgan’s timely intervention demonstrated how this could be done:

Shipments of gold were on the way from London to New York, and confidence had returned to the French Bourse, “owing,” reported one paper, “to the belief that the strong men in American finance would succeed in their efforts to check the spirit of the panic.” During a panic, confidence is almost as good as gold.

As politicans saw how these crises could be contained – and as they realized Morgan who had successfully beaten back several of these panics was getting near his end – they created the Federal Reserve to officially take on the role Morgan had been unofficially occupying, the lender of last resort and de facto regulator. 

As panics are short, they generally do not affect the fundamentals of the economy – but in a liquidity crisis such as this, restoring confidence is a more delicate task. It involves restoring what John Maynard Keynes referred to as “animal spirits” – those positive energies that cause people to be trusting and optimistic that are essential to a thriving economy. As Keynes wrote in his seminal work, The General Theory of Employment, Interest, and Money:

Even apart from the instability due to speculation, there is the instability due to the characteristic of human nature that a large proportion of our positive activities depend on spontaneous optimism rather than mathematical expectations, whether moral or hedonistic or economic. Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits – a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities. [my emphasis]

This idea of animal spirits has created an opening for what appears to be Obama’s favorite branch of economics – behavioral economics. While economics generally treats human beings as homo economics, rational, self-interested (indeed, selfish), individuals who act entirely to serve their best interest (and who know what their best interest is) – behavioral economics takes a more scientific view of human beings. They try to understand human behavior through testing and real-life examples rather than through theoretical models. Some of Obama’s top advsiors from Cass Sunstein to Austan Goolsbee are known to be proponents of behavioral economics. And a recent article by Chrystia Freeland in the Financial Times, suggests that Obama’s administration may be using behavioral economics to solve this crisis, describing how “emotions might yet save the economy“:

Judging by the upbeat economic message we have been hearing from the White House, the Treasury and even the Federal Reserve over the past six weeks, that is a shrewd guess. The authors argue that “we will never really understand important economic events unless we confront the fact that their causes are largely mental in nature”. Our “ideas and feelings” about the economy are not purely a rational reaction to data and experience; they themselves are an important driver of economic growth – and decline.

I don’t have the expertise to judge if this crisis is one of solvency or confidence or whatever else it may be. But at this point there is a feeling – almost of a wind at the back of the economy. (I certainly hope this is the case.) It does seem to me that the lack of confidence is a major cause (rather than merely a symptom) of this crisis; and Obama’s gradualist approach, with every move telegraphed and thus predictable – seems to be generating confidence.

Must-Reads of the Week

Friday, May 8th, 2009

1. Inhuman. Andrew Sullivan, who has been one of the most insightful commenators on torture, discusses the term “inhuman”:

It’s odd, isn’t it, that we use this word to describe abuse and torture of prisoners. The reason it’s odd is that I’m not sure any animals torture. Yes, they can kill and maim and inflict dreadful suffering in the process of killing, eating or fighting. But the act of intentionally exploiting suffering, of lingering over some other being’s pain – using it as a means to an end – is not an animal instinct, unless I’m mistaken.

And so torture is in fact extremely human; it represents in many ways humankind’s unique capacity for cruelty.

2. 30 Rock. Jonah Weiner discusses 30 Rock’s odd conservative streak at Slate. The explanations he posits for this conservatism are perhaps beside the point, but interesting nonetheless:

Of course, 30 Rock was conceived during the reign of George W. Bush, which might help explain its ideological complexity. The show has been consistently critical of Bush, but perhaps 30 Rock began as a way to explore—and mine for gallows humor—the crisis of identity many liberals began to feel in his second term, when the Karl Rove playbook had seemingly replaced the laws of physics, when the “reality-based community” (including Liz Lemon’s Upper West Side) felt like an island populated by the marginal, flip-flopping, arugula-munching few.

3. Animal Spirits. Chrystia Freeland writes for the Financial Times that the Obama team seems to have accepted the premise of a recent book by behavioral economists about economic crises:

Judging by the upbeat economic message we have been hearing from the White House, the Treasury and even the Federal Reserve over the past six weeks, that is a shrewd guess. The authors argue that “we will never really understand important economic events unless we confront the fact that their causes are largely mental in nature”. Our “ideas and feelings” about the economy are not purely a rational reaction to data and experience; they themselves are an important driver of economic growth – and decline.

4. A Taliban Strategist Speaks. To The New York Times. Perhaps the most interesting article I have read about the Taliban’s plans in the Af-Pak region – though I have to wonder why this man would be speaking to a Western newspaper about the Taliban’s strategy. That said, you can judge the article for yourself. I pass it on as it seemed plausible to me:

One Pakistani logistics tactician for the Taliban, a 28-year-old from the country’s tribal areas, in interviews with The New York Times, described a Taliban strategy that relied on free movement over the border and in and around Pakistan, ready recruitment of Pakistani men and sustained cooperation of sympathetic Afghan villagers.

His account provided a keyhole view of the opponent the Americans and their NATO allies are up against, as well as the workings and ambitions of the Taliban as they prepared to meet the influx of American troops.

It also illustrated how the Pakistani Taliban, an umbrella group of many brands of jihadist fighters backed by Al Qaeda, are spearheading wars on both sides of the border in what for them is a seamless conflict.

5. Fool’s Gold. This one is actually a must-listen podcast of a talk given at the London School of Economics. Gillian Tett is a journalist for the Financial Times who recently wrote a book about the financial crisis and what led to it from her view as someone with a background in anthropology reporting who was reporting on derivratives before it was an exciting beat.

Bonus: Polar Insanity. Tim Wu writes in Slate about the perplexing desire of so many people – including himself –  to make the expensive trips to the polar regions:

Every so often, an iceberg floats by that is grander and more beautiful than any cathedral, though it lacks any history or even a name. What’s almost as shocking as its appearance is its anonymity: beauty untainted by fame. Most of these perfect objects will never be seen by human eyes. They float around and slowly melt by themselves, unappreciated and utterly indifferent to that fact.

Unnamed, plentiful beauty feels unearthly and almost decadent, like Sinbad the Sailor’s cave. It is alien to the typical human experience of finding everything we really desire to be scarce, expensive, or behind some temple curtain. It has always struck me that no one bothers to build museums in places of extreme natural beauty, and in Antarctica the effect is magnified. If an iceberg the size of Manhattan showed up outside town one day, why would you bother going to an art exhibit?